California Real Estate and the Neurosurgeon

What does California real estate have to do with neurosurgery? If you are thinking about investing in California real estate, you need to have your head examined.

Before I start ranting, I would like to disclose that I have no political affiliation whatsoever.

March 2012, two Stanford professors (Boskin and Cogan) wrote an excellent op-ed in the Wall Street Street entitled "
California's Greek Tragedy". It is short, to the point, and well worth the few minutes to read it. The elections are over. California has made a commitment to exactly the reverse direction that the professors had hoped for.

Starting with Proposition 30, the sales tax increase and the income tax increase for the top 1%, the California version of the fiscal cliff has been averted for now, with $6 billion in estimated increases in revenue. Here is the
State Budget.  There is nothing but patchwork and political jargon in there, claiming among other things that

"……the Budget will be balanced in an ongoing manner. This represents the first time in over a decade that future spending is expected to stay within available revenues."


I have no reasons to believe that as we approach the end of the financial year next spring, California won't be running out of money once again.

As per Proposition 30:

"…..These new tax rates would affect about 1 percent of California PIT filers. (These taxpayers currently pay about 40 percent of state personal income taxes.)"


There are about 16.5 million tax returns for California according to the IRS, so 1% is only 165,000. I wonder if a few hundred of these 1%ers were to decide they have had enough and leave, taking whatever business they have with them, would it negate every extra dime in revenue that Proposition 30 was hoping to achieve? Furthermore, I wonder how many households with greater than $500k taxable income would choose to move to California?

After the elections, California not only has a Democrat as Governor, we have a super majority of Democrats in both the State Senate and Assembly. This is the unadulterated tax and spend party, supported strongly by the give-me-more unions. They have just raised the sales tax and income taxes for the rich, so where else can new revenue come from?

The answer: REAL ESTATE. Proposition 13 from the 1970's allowed Californians to cap the property tax. That is now an easy target, especially for commercial properties. 1031 Tax Deferred Exchanges would most likely be high on the list, especially for out of State exchanges. I don't wish to debate the merits of Proposition 13 here, but any repeal, or just talk of a repeal, will be detrimental to California real estate. While businesses that are not State dependent may procrastinate and many more may move out, new businesses certainly have no reason move in.

More unpredictable is the new round of rules and regulations that California is famous for. Pertaining to real estate, my biggest fear would be increased "tenant rights", rent control or other creative restrictions. What if I purchased a property with a reasonable vacancy allowance and the law changed, lengthening the eviction process. It would blow my profit/loss projections then and there. The same would apply to any businesses that are in the State today. Who in their right mind would think about relocating their business to California if one doesn't know what the legislature may be plotting? The direct impact to California real estate is through employment growth. No jobs, no housing.

Then there is the demographic squeeze. California has always had a much lower home ownership rate than the nation's average and it may go lower. First Tuesday, a California Real Estate Journal, recently published an article entitled "Will first-time homebuyers save California’s homeownership rate?"

First time buyers are not going to support California real estate for the indefinite future. Fat cats looking to retire in coastal California may question why they would want to move here and pay the extra taxes. Middle class retirees who can only afford the Inland Empire or Central Valley can find equally miserable locations to move to, such as Phoenix, only they're cheaper.

The consensus is quite contrary to my views. In Silicon Valley, real estate is on fire, fueled by Facebook, Apple and Google bucks.  Many markets are reporting growth in sales, median prices and a lack of inventory. I believe it is all noise and very temporary. To illustrate this, take a look at the most recent data for September, as reported by DQNews. DQ utilizes unmolested recorded data and is extremely accurate.

In Southern California, investors purchased 27.3% of all closings. 25.2% utilized FHA financing while 31.5% paid cash. Does that make sense? Why would anyone pay cash when the Fed Chairman is begging everyone to borrow at ridiculously low rates? (September was before QE3, but rates were not much different). For the Phoenix area (Maricopa-Pinal Counties), investors purchased 38.6% of the closings. 24.7% utilized FHA financing while 39.6% paid cash. For Las Vegas, a whopping 48.5% was purchased by investors. 35.2% utilized FHA financing while a mind-boggling 52.4% paid cash. I am using Phoenix and Vegas because they are typically overflows of investors from or in California.

This is nuts.  All these investors and cash buyers may be happy with a low yield today, as anything seems better than the miniscule return from other fixed rate instruments. Have they considered that they have an embedded loss? What if rates normalize or possibly go parabolic? Can you imagine what is going to happen to the less than 4% cap rate rental if the 10 year treasury note yield is 4%? (As recently as 2007, before the 'QE' exercises, the 10 year treasury yield was over 5%.)

In summary, California is entering a phase where demographics are most unfavorable. The political environment is even more business unfriendly than it was previously. Chairman Mao and Comrade Stalin showed the world that it is evil to be a landlord. California may be taking a chapter from their manifestos. Having enjoyed the fruits of California real estate ownership since 1975, I have never seen such uncertainty as we face today. Current prices, in my opinion, are not remotely low enough to offset the risk.



Get thee hence, evil landlord!

(Photo via Wikimedia Commons)



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One Response to “California Real Estate and the Neurosurgeon”

  • Floyd:

    The future will tell who had the upper hand: those converting cash into RE, or those holding on to their cash waiting for better valuations.

    Given how much cash is despised, it may be the time to hold on to it…
    But, boy, this is frightening with all the ZIRP and QE around…

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